IRS Cost Segregation Audit Techniques Guide Explained

The IRS cost segregation audit techniques guide is an internal IRS manual issued in April 2004 under the jurisdiction of the Large and Mid-Size Business Division. It provides revenue agents with a comprehensive framework for auditing cost segregation studies, covering the legal basis for cost segregation, acceptable and deficient methodologies, documentation requirements, and the characteristics of a quality study.

The irs cost segregation audit techniques guide is not a regulation or ruling, but it carries significant weight because it tells taxpayers and providers exactly what the IRS will look for during an examination. Studies designed around the ATG's framework are far better positioned than those that ignore it.

The guide is organized into chapters covering: background and legal framework, the engineering methodology, common issues encountered on audit, specific asset type analysis, and the 13 elements of a quality study. It is publicly available on the IRS website and should be reviewed by any provider or CPA involved in a cost segregation engagement.

The ATG traces the legal authority for cost segregation to the Tax Reform Act of 1986, which established MACRS depreciation, and to prior case law allowing component cost allocation. The core legal premise is that property must be classified according to its actual character, not simply according to how it was originally placed on the depreciation schedule.

The guide references the asset class definitions under Revenue Procedure 87-56 and the general depreciation rules under IRC Section 168. It distinguishes between Section 1245 personal property and Section 1250 real property, which determines not only the depreciation life but also the recapture treatment on sale.

The irs cost segregation manual identifies four primary methodologies in order of reliability. The most reliable is the detailed engineering approach from blueprints, which involves a cost estimate of each component derived from construction drawings and a site inspection. This produces component-level costs that can be traced to specific depreciable asset categories.

The engineering approach from actual cost records is also considered reliable. This method uses actual contractor invoices and construction documents to allocate costs to specific components. It requires complete cost records, which are not always available for older properties.

The survey or letter approach involves surveying current costs of replacement components and extrapolating to the original cost basis. It is considered acceptable when actual costs are not available but requires careful adjustment for time and market differences.

The cost segregation ATG explicitly identifies approaches the IRS considers deficient. Primary among these is the residual method, which allocates a portion of total cost to land and specific personal property, then treats whatever remains as real property. The ATG notes that this method does not require analysis of each component and may result in inaccurate classifications.

Rule-of-thumb percentage allocations without engineering support are also flagged. These approaches apply industry averages to the total building cost rather than analyzing the specific property. While they may produce results within a plausible range, they are not defensible if the IRS requests support for each classification.

The ATG provides extensive guidance on which types of assets the IRS views as potentially classifiable as personal property. This includes specialized electrical systems that serve specific equipment rather than the building structure, process piping, flooring with special functionality, and land improvements such as parking lots, landscaping, and site lighting.

The irs cost seg guidance uses a facts-and-circumstances test that considers: whether the asset is attached to the building, whether it serves the building or a specific business function, and whether its removal would damage the building. These factors derive from court decisions and IRS rulings that predate the MACRS system.

The irs audit guide cost segregation section on documentation is detailed. The guide expects every component classification to be supported by documentation tracing that component to its original cost basis, its physical description, the reason for its classification, and the authority supporting that classification.

Adequate documentation includes: construction contracts and change orders, architect or engineer drawings, site photographs, appraisal reports for older properties, depreciation schedules reconciling to the tax return, and a narrative of the methodology applied. Each of these serves a specific function during examination.

When a return with cost segregation deductions is selected for examination, a revenue agent trained in the ATG will typically begin by requesting the full study report, supporting workpapers, and the preparer's credentials. The agent will review the methodology chapter of the report against ATG standards.

The agent may then request specific asset-level documentation for components the IRS considers high-risk: land improvements, specialized electrical, and assets where the personal property classification requires factual analysis. Examinations often focus on a sample of assets rather than reviewing every line item.

The 2004 ATG predates many of the bonus depreciation rule changes introduced by the Tax Cuts and Jobs Act of 2017 and subsequent legislation. However, the asset classification methodology it describes applies equally to studies that include bonus depreciation-eligible components, since the classification of an asset as personal property or 15-year land improvement is a prerequisite to bonus depreciation treatment.

Studies that include bonus depreciation claims face the same scrutiny on asset classification as any other study, with the added stakes that bonus depreciation amplifies the deduction in year one. Accurate classification and complete documentation are especially important when bonus is claimed.

The most practical application of the ATG is in study design. A provider who builds every study to meet ATG standards from the outset creates documentation that is examination-ready without additional preparation. This includes engineering analysis, contemporaneous site documentation, a complete asset register, and a methodology narrative that references the appropriate legal authority.

For the next level of detail on quality standards, the 13 elements of a quality cost segregation study provides a comprehensive checklist derived from the ATG. To understand the legal precedents that underpin the ATG's classification framework, see cost segregation case law and key court rulings.